Upside-down on a Loan?

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It is common knowledge among automotive salespeople that roughly two-thirds, more or less, of all new-car buyers who walk into a dealer's showroom have a current car to trade in, and roughly two-thirds of those, more or less, owe more on that existing vehicle than its trade-in value. If you owe more on something than it's worth, in the terminology of the industry that is known as being "upside-down," and it applies to roughly half of all new-car buyers. This didn't used to be so common, as there was a time when a prudent buyer tended to purchase a car and diligently pay it off. But, with incentives on the rise, low-interest, long-term loans dominating the financial landscape and increasing numbers of buyers over-extending themselves by seeking instant automotive gratification, more people are finding themselves in the situation of owing more on the vehicle loan than the car is worth.

In a market that pushes the newest, latest car designs, many people feel they have to get into a new car -- whatever it takes. Others simply don't feel comfortable driving a car that is out of warranty or has a lot of miles on the odometer. Whatever the reason, the fact remains that dealers and financial organizations are willing to accommodate these purchases by making deals that roll-over the debt owed from the trade-in and add it to the financing for the new car with, understandably, a higher loan amount over a longer period of time. This is done to keep the monthly payment low enough to be affordable. What sometimes doesn't get noticed by the buyer is that he or she is now making payments on two cars -- the new one and what was left of the old one -- and taking a very long time to pay it all off.

Furthermore, when a buyer is described as being upside-down it is quite often not for just a few thousand dollars. Many buyers are upside-down by 10 or 20 thousand dollars, or even more and, at their current rates, it will be years before they are even.

Why is this so common?
The combination of hefty incentives, smaller down payments and the general willingness on both financial and dealer organizations' parts to create roll-over loans has influenced the market to accommodate lenders' needs and find creative solutions to getting buyers into new vehicles. Some of these methods are less desirable than others but, ultimately, it's a personal financial decision a car buyer must make before taking the plunge. And, in truth, the real reason many people are so far upside-down is because they were too eager to get a new car and didn't consider the financial consequences. When a buyer is heavily upside-down, it didn't happen by accident.

Understand Your Position
Don't know if you're in this situation? To find out, simply look up the trade-in value of your current vehicle -- be sure to rate your vehicle's condition by selecting the "Rate It" link on the pricing pages. If your trade-in value is less than the balance of your current car loan, you are upside-down by that amount; if you were to trade in that car on the new car, you would still have to give the dealership the additional money just to come out even on the trade. Check out your car's private party amount. Is it still less than your debt? If not, you may want to try selling it yourself.

Understand Your Options
If you find yourself in this position, you have several options -- each with benefits and risks attached:

Option 1: Roll-over the existing debt to a new car loan

The biggest benefit to choosing this option is that you will be able to drive that new car off the lot, possibly for a comparable monthly payment.

You will probably be asked to finance a long-term loan, which means you will owe a lot more than the new car is worth, and is going to be worth, for an even longer period of time.

Option 2: Find a new car with an incentive amount that covers your debt

This finance trick is great for covering the amount of your trade-in debt and will eliminate the roll-over effect.

Remember that with most incentivized vehicles the resale value is taken out of the car up-front. In other words, you'll find these cars' values drop faster than other cars that do not have incentives, thus placing you in another upside-down position later. NOTE: This is still less risky than Option 1 because, in this case, the manufacturer has absorbed part or all of the negative balance.

Option 3: Keep the car you have until its value catches up

The obvious benefit here is that you will have equity to work with when you're ready to look for a new car. Generally, this is the wisest financial choice and, taken to its logical conclusion, it will get you back on top of things. But it doesn't satisfy many buyers' desires for instant automotive gratification.

The only risk is that your car could have excessive miles and damage, reducing the amount you have to barter with. But, if you can live with it for a while and pay it off, you will eventually be back in a much better financial position.

Option 4: Refinance your existing car with a shorter-term loan

Third-party financial companies, like LightStream, an online lending division of SunTrust Bank, offer refinancing loans that could speed up the time it takes to get your loan healthy.

You risk missing out on getting those new wheels, of course, but you may also find yourself outside your current car's warranty coverage and accumulating a lot of miles on it. And, to restructure in this way will almost certainly mean your monthly payments will increase -- after all, you're refinancing the remaining portion of an existing loan over a shorter time period.

As you can see, both consumers and dealers are coming up with highly creative ways to deal with this growing issue. The biggest danger is that rising interest rates -- even increases as small as one percent -- could equate to an increase of several hundred, or even a few thousand dollars over the life of the loan. With some loans being financed for terms as long as 96 months (eight years), the effect of rising interest rates and the practice of rolling-over an existing loan into a new one could result in an unfortunate situation that would negatively affect your personal financial health. And all for a new car.

Avoid Being Upside-Down Again
Finally, here is some general advice on things you could do before you pursue your next car purchase:
  • Educate yourself on your credit score don't pay a higher interest rate than you need to.
  • Educate yourself on available interest rates in the marketplace before applying for a loan; know a good rate when you see one.
  • Do plenty of pricing research on available new car and trade-in values to get a good value on both transactions.
  • Match your loan to your expected ownership length of time; a longer loan will help keep monthly payments low, but chances are it will lead to being upside-down when the time comes to trade in for yet another new car.
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